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A Worthwhile Read
on November 27, 2012
Gorton makes four very important points:
(1) Financial crises always arise when the public (individuals or businesses) lose faith in bank debt. According to Gorton, creating debt is the main business of banls. It is this debt that enables our economy to function. Unfortunately, in times of rapid expansion, banks create debt too quickly and so become fragile.
(2) Financial crises are always characterized by bank runs. These can be very visible, e.g. depositors lining up to get their money back. Or they can be invisible, e.g. lenders in the shadow banking system, who typically lend for a day or so at a time, refusing to roll over the loans to suspect banks. It follows that the real problem is not banks that are under-capitalized, but banks that are illiquid, i.e. they don't have enough cash on hand to meet demands. (They could have lots of illiquid assets, but so what?)
(3) The banking sector is so essential to the economy that governments will not let it go under. In this sense, banks have been "too big to fail" for at least two centuries. The tool used by the government evolves over time -- suspensions of withdrawals and "bank holidays" in the nineteenth and early twentieth centuries, the Fed as lender of last resort and deposit insurance in the twentieth century, bailouts via purchase of toxic assets in the twenty-first. Each time the popular reaction is fury: Populists wanted to hang the bankers a hundred and fifty years ago, a hundred years ago, etc.
(4) Both fortunately and unfortunately, financial innovations allow banks to create new forms of bank debt to satisfy the growing demand for such debt. Asset-backed securities and CDOs are just the latest in a long line, e.g. checking accounts, credit cards, and so on. Government is usually one or two steps behind. Indeed, with the disappearance of the physical queue of depositors clamoring to be paid, the government now has difficulty recognizing when a bank run occurs, and tends to intervene too late.
Gorton's solution is more regulation. That may be controversial, but Gorton's case is very well argued. He examines in detail financial crises over the past two hundred years (although he limits himself almost exclusively to the U.S.). The lessons he draws lead him to the above conclusions, plus a number of other insights.
Unfortunately, as with his previous book, Slapped by the Invisible Hand, this book is very badly written and could use a strong editor or even a rewrite. It is repetitious in many places, the author jumps around a bit, and may sentences are just plain awkward. When he quotes at length a nineteenth-century author, that comes as a relief. For this reason, I'm giving it four stars instead of the five that the content richly deserves.